The Term Structure of Realized Risk Premiums in Currency Forward Markets

Abstract

We examine the term–structure of realized risk premiums in the Australian Dollar-USD forward market. We find positive and time-varying risk premiums, while the magnitude and significance of the premiums increases with maturity of the contracts. We then examine the relationship between realized risk premiums and explanatory variables such as spot currency returns, the forward premium, realized variance, skewness and kurtosis of spot currency returns. Our results illustrate the significance of the considered variables for explaining the observed risk premiums. We then apply principal component analysis to examine the term structure of risk premiums at different maturity levels of the forward contracts and explain the dynamics of the observed premiums through a smaller number of common factors. We obtain a four–factor model that explains over 90% of the total variation in the term structure of risk premiums. Interestingly, the factors can be suitably labelled as ‘level’, ‘slope’ and ‘curvature’. Further, the first factor is found to be related to the realized variance of currency spot returns, the second factor can be related to the realized kurtosis, while the third factor is related to the forward premium and realized skewness of spot currency returns. Our results provide new and important insights on the behavior of currency forward risk premiums at different maturity levels.

Keywords: Currency Forward Markets, Term Structure, Risk Premiums, Principal Components, Factor Analysis

JEL Classification: F31, G15. G13